The Financial Times reported today on a spike up in the ABX index, a means to buy and sell default insurance on mortgage-backed bonds rated BBB- (the very bottom of investment grade bonds) are now trading at nearly 1000 basis points, up from 650 a week ago, a dramatic increase.
The reason? More bad news in the subprime market. ResMAE, a California subprime lender, filed for bankruptcy today. The FT cited other troubling developments:
HSBC and New Century, warned they had underestimated the spike in defaults on so-called sub-prime mortgages….
KB Home, the fourth-largest US housebuilder, said deteriorating lending conditions could affect the projected recovery in housing….
Peter DiMartino, asset-backed securities strategist at RBS Greenwich Capital, said the reason for the sell-off included fears that more lenders would announce bad news.
“With the downward momentum so strong, few investors have been brave enough to express a contrarian point of view,” he said.
Despite the carnage in the subprime sector, analysts don’t yet see a threat to other sectors of the credit market. Indeed, as a Bloomberg article describes, Merrill Lynch, along with Deustche Bank, Barclays, and Morgan Stanley, have taken advantage of the distress to acquire subprime mortgage companies, hoping to make headway on Bear Stearns as the leader in the subprime origination market. The Wall Street firms earn handsome fees from packaging the loans and selling them to other investors.
Merrill may be shrewdly buying near the bottom, or trying to catch a falling safe. The real question is whether the contraction in the subprime market is cyclical or secular. One observer, quoted in the Bloomberg story, thinks the worst has yet to come:
“We still have way too much capacity,” said David Olson, president of Wholesale Access Mortgage Research & Consulting in Columbia, Maryland, and the former director of market research at Freddie Mac, the second-biggest financier of U.S. mortgages. “That means a lot more firms have to go out of business.”
If investors lose their appetite for subprime paper and the industry contraction is lasting, Merrill’s purchases won’t look as clever.